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Thursday, January 18, 2007

LIABILITIES IN EXCESS OF BASIS NOT A PROBLEM IN SOME SECTION 351 TRANSACTIONS

Under Code Section 351, taxpayers generally do not recognize gain or loss when they transfer assets to a corporation in exchange for control of the corporation. An important exception to this rule is Code Section 357(c)(1), which provides that if the transferee corporation assumes liabilities of the transferor in excess of the adjusted basis of the transferred assets, the transferor recognizes gain to that extent.

At times, a Code Section 351 transaction can also qualify as an acquisitive 'D' reorganization under Code Section 368(a)(1)(D). That provision generally allows for the acquisition of assets of one corporation by another commonly controlled corporation in exchange for stock of the acquiring corporation. Thus, when there is a transfer between commonly controlled corporations the transfer can constitute both a Section 351 transfer and a 'D' reorganization.

Previously, 'D' reorganizations were subject to the same gain recognition rule under Section 357(c) for liabilities in excess of basis as Section 351 transfers. However, under the American Jobs Creation Act of 2004, 'D' reorganizations are now NOT subject to Section 357(c). So what happens if the acquiring corporation assumes liabilities of the transferring corporation as part of the transaction that are in excess of the adjusted basis of the transferred assets when the transaction qualifies both under Section 351 and a 'D' reorganization? This issue was recently addressed in Revenue Ruling 2007-8.

Under the Revenue Ruling, the IRS concludes that Section 357(c) will not apply, per 'D' reorganizations not being subject to it (even though Section 351 transfers are subject to it). It also noted that an overlap can exist between a 'G' reorganization and a Section 351 transfer, and that Section 357(c) will not be applied in that situation either.

Why did Congress change the law in 2004 to exclude 'D' reorganizations from the reach of Section 357(c)? The Ruling advises that this was done because in such transactions the transferor ceases to exist and cannot be enriched by the assumption of its liabilities. It further shows that the amendment was made to conform the treatment of 'D' acquisitive reorganizations to the treatment of other acquisitive reorganizations.

Rev. Rul. 2007-8, 2007-7 IRB

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